Managing the LPAC: Trust, but clarify

Before 2008, a seat on the limited partner advisory committee (LPAC) was seen as a carrot dangled before investors to secure a commitment. But the days of membership being a mere perk are over.

Now LPACs are seen as a vital tool in managing a fund, and are responsible for significant oversight. However these duties can tax busy LPs, and some investors don’t have the time or inclination to resolve fund conflicts, leaving the sponsor without the votes to render a judgment on key issues facing a fund. LPs may also grow impatient that certain GPs don’t provide enough information, or time, to render an adequate decision.

In response, many firms are defining the terms of LPAC membership in real detail, in charters separate from the LP agreement. These charters are informed by their own experience and guidelines by the Institutional Limited Partner Association (ILPA), a trade body for private equity investors. While certain terms are best made explicit, the nature of private equity ensures there will always be issues or situations that can’t be predicted. Hence GPs would do well to err on the side of robust, regular disclosure to build trust for unforeseen situations that would benefit from a sympathetic LPAC.

“As LPs have grown more sophisticated, LPACs have become less ‘chummy.’ Not more adversarial, simply more professional,” says Margot Wirth, director of private equity at the California State Teachers’ Retirement System (CalSTRS), a pension plan that sits on various LP advisory committees. Several market participants cited the financial crisis in 2008 and the ensuing market volatility for making LPs even more rigorous in their duties as fiduciaries.

“Before the crisis, LPACs could be a little passive,” says Justin Storms, a funds partner with law firm Linklaters. Storms explains that after enduring the public criticism and uneven performance of their broader portfolios, investors became less willing to grant consent. 

At the same time LPs, especially public pensions, are more hesitant to approve any conflicts of interest for fear these decisions would catch the interest of regulators, participants or the public at large. That fear may make them more activist in nature, but it also may inhibit them from weighing on those very issues. Like any other public official, LPs are aware that voting on the record can open them up to criticism and perhaps even legal action.

“Some LPs want the benefits of membership on an LPAC, such as more information or what they see as access to co-investment opportunities, but prefer not to vote on controversial issues. Instead, they prefer to ‘abstain’ from such decisions,” says Raj Marphatia, a funds partner with law firm Ropes & Gray. This paints them into a corner, since LPAC membership is often a requirement for commitments of a certain size.

But for LPs willing to vote on such matters, GPs can frustrate them by waiting too long to share information. “When it’s a complicated issue, GPs shouldn’t drop a stack of 150 pages on the lap of the LPAC and ask for a decision in two days,” says Jason Ment, general counsel and chief compliance officer of StepStone Advisors. “It’s not respectful of your partners.”

These data dumps are among the most common complaints of LPAC members. “We understand that in certain cases, GPs don’t have the luxury of a long lead time to inform the committee. But in cases where GPs wait until the last minute with no good reason, it can cause resentment. You need to give LPs a chance to absorb the information, do some research, and discuss it amongst themselves,” says Wirth.

Another common gripe from LPAC members is the quality and timing of disclosures. If an investor is hesitant to vote on a matter, they won’t feel more confident with less time or less information to do it, say LP sources. And both investors and fund advisors say there is too often a lack of clarity in how the two sides should collaborate on issues facing the fund.

DEFINING THE RELATIONSHIP

ILPA issued guidelines on LPAC best practices in 2009, and then revised them in 2011. ILPA recommends that when GPs offer seats to LPs, the invitations should include information on meeting schedules, expense reimbursement procedures, an outline of LPAC duties under the LP agreement (LPA), and a statement of indemnification. Clear voting thresholds and protocols should be established, including requiring a quorum of 50 percent of the LPAC when votes are taken. And as soon as the fund closes, the GP should circulate a list of LPAC members to the rest of the LPs.

ILPA also outlined what LPAC members owe the fund, in that they must review and approve transactions that present any conflicts of interest, such as cross fund transactions, any methodology used for portfolio company valuations and any other consents or approvals pre-defined in the LP agreement. ILPA’s guidelines state clearly: “LPAC members should participate in all LPAC meetings, be properly prepared and responsibly fulfill the duties of the role.” ILPA even went so far to suggest the best way to manage the meetings themselves (see boxout).

Many GPs took the recommendations to heart, with some firms issuing ten to fifteen-page “charters” detailing LPAC duties and procedures, separate from the LP agreement. “You want these policies to be disclosed and transparent, but it’s better to keep the charter documents separate from the LP agreement,” says John O’Neil, a funds partner at law firm Kirkland & Ellis. “No one wants to get bogged down in protracted legal negotiations when it comes to these policies.”

For GPs, the terms spelled out in these charters are fairly simple. “Number one, you have to emphasize to members that they have a duty to attend meetings and to vote on issues presented to the board by the sponsor,” says Marphatia. “You have to make it clear, if you don’t show up on a regular basis, or you decline to vote too many times without a good reason for doing so, you’ll be asked to leave the board.” In their latest guidelines, ILPA recommends that GPs set forth procedures for removing and replacing any member of the LPAC.

Lawyers, GPs and LPs agree that the terms that matter most to investors in these charters are common sense items, for example robust, consistent disclosure on expected issues. And sufficient time, usually ten days or so, when possible, to review information pertaining to the unexpected, like key man events and conflicts of interest. But LPs do have some priorities that GPs might not be aware of when first offering a seat on the board.

In-camera (private) sessions, or a chance for LPAC members to debate without the GP present, were mentioned frequently as a priority. “The interests of the GPs and LPs are aligned in many things and you are partners in many respects, but on some issues your interests are not aligned,” says Wirth. “The GPs meet and discuss without LPs present, so we like to make it matter of course that there is an in-camera session every time the board is convened.”

LPs also want the ability to hire outside counsel or advisors at the expense of the fund. “The GP and the LPs agree it can be important to use outside resources, but you have to make sure your LPAC is all on the same page as to when and how the adviser is used,” says O’Neil. “When you’re faced with a crisis and the LPAC must make a difficult decision, there may be a hesitancy to move on it, so LPs get comfort, and the board can act with more functionality, with that outside guidance.”

But in what detail should these charters or LPAs address what constitutes a conflict worth convening the LPAC for?

There are issues such as principal transactions or key man exits that absolutely should be defined in the charter and lend themselves to LPAC consent,” explains Storms. “But for many deal-related matters, such as charging transaction fees that an investment bank might otherwise receive, it might be better to address LP concerns with disclosure, reporting such actions in a consistent and complete fashion, instead of requiring consent for each and every move the GP makes.” Storms admits this might result in a few upset LPs, but GPs are more likely to self-police when they know they’ll have to justify their decisions after the fact.

“95 percent of successfully working with your LPAC comes down to developing a true relationship with your investors based upon good, active communication and robust and relevant reporting,” says Terry Mullen of mid-market private equity firm Arsenal Capital. “If you share the bad news as well as the good, you’ll build trust. The rest of the relationship is about judgment calls and that takes a dialogue, which again is rooted in being as forthright as possible.”

“Today’s LPAC members are saying, ‘Look, we’re not doormats, but we’re not assassins either’. We’re partners with responsibilities and we’re going to discharge them,” says Storms. And if the GP offers a clear framework for that partnership, they might find the LPAC is a valuable ally, no matter what issues the fund faces, he adds.